Credit - Pain & Gain

"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle 

Looking at the continued rally in the credit space, with the Iboxx Euro Corporate benchmark tightening to the tune of 5 to 6 bps every week in the last three week in the cash market, in conjunction with the massive compression of spreads in the Itraxx Credit indices space, we thought this week, we would use a reference to 1999, New Times three-part series of articles called "Pain & Gain" by writer Pete Collins which inspired 2013 American film directed by Michael Bay.  The story revolved around a gang of local bodybuilders with a penchant for steroids (liquidity from central bankers?), strippers, and quick cash. They later became known as Miami's Sun Gym gang and quickly developed a taste for blood and money.

Gain: 

We closed the week on almost 15 bps on Itraxx Main Europe to 92, the lowest since May 2010, which is the risk gauge for Investment Grade credit, and 50 bps in Itraxx Crossover to a low of 378 bps. 

Pain: 

As one credit index trader put it in his closing comments (which are reminiscent of the early days of 2007):

"With street put short yesterday by the massive short cutting, dealers are finding it hard to recycle positions and were having more and more pain as client kept selling index today as well. With shallow volumes, every enquiry drove the market lower. The incredibly strong payrolls drove us through 90 and this was the point when people were starting to have discussions of whether these tights are the new fair trading range or whether they should put those shorts."

 

There you go, the penchant for steroids induced rallies in the credit space is starting to inflict some serious pain to market makers as they are having to bid for credit indices and getting hit in a severe tightening market, not only inflicting P&L pain, given they are having trouble recycling their positions with less players in the market place than in 2007 (gone are the prop traders, fewer credit hedge funds and fewer market making banks) but, they are also facing negative carry on the trades they have had to absorb and did not recycle. Oh well...

So this week, we will focus our attention to the credit space, the releveraging taking place in the US and Mario Draghi's ambition of reviving the Euro Zone Corporate lending . But first, a quick market overview.

The absolute level of core European government yields has continued to fall even after the 25 bps rate cut this week - source Bloomberg:

2 year Italian yields dropped to 1.068% the lowest since Bloomberg started tracking the data in 1993 and Italian 10 year yields fell 7 bps to 3.84% the lowest since October 2010. Spanish yields also receded with the 10 year falling to 3.97% below 4%, the least since October 2010 and 2 year below 1.60%, the lowest since April 2010.

Credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going negative again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit wise the rally in 2012 has been epic courtesy of "whatever it takes 1" (Mario Draghi) and "whatever it takes 2" (Abenomics). Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities) - source Bloomberg:

The absolute spread between both credit indices is closing to the level of March 2011 (255 bps apart) before the liquidity crisis of summer 2011 which was tempered by a good dose of "steroids" (LTRO 1 and 2).

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

We are back to early 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

While the Eurostoxx seems struggling to break the 2800 level, the German 10 year Government yields have touching record low levels this week towards the 1.16% yield level  and the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) have been dramatically falling towards 140 in the last couple of weeks while volatility remains muted at 18 for the V2X index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

We already indicated that divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", was here to stay in 2013. This divergence can be seen as well in the difference in credit spreads risk gauges such as the Itraxx Main Europe CDS index and its US CDX counterpart - source Bloomberg:

What has been interesting has been the strong correlation between the US, High Yield and equities (S&P 500) since the beginning of the year. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:

Talking about Pain and Gain, whereas March was brutal for investment grade, the rebound in April has indeed been very significant. As one can see the correlation between High Yield and equities seems to be stronger than ever as both the S&P 500 and the ETF HYG seems to be perfectly moving in synch.

But, if we focus our attention this week on credit, we would have to say that the unintended consequences of "steroids" induced policies from Central Banks is pushing investors more and more up the risk spectrum as everyone is seeking higher returns as indicated by Fitch recent European High Yield Chart book:

"As yields continue to compress in high yield, the risk-reward proposition for the investor becomes increasingly difficult to justify, shifting the dynamics in favour of issuers. European non-financial BBs now trade equal to equivalent US BBs, despite materially weaker growth, greater policy volatility and uncertain liquidity. European Bs continue to offer premia, though these too are tightening. Global monetary stimulus from quantitative easing in the US, the UK, and Japan together with an expected ECB rate leaves little choice for investors other than to move out along the maturity curve and go down the credit spectrum to seek diversification as they satisfy return objectives.
Deteriorating credit quality poses a risk to the market, but this is largely expected to translate into a migration of ratings to lower levels rather than any substantial increase in the default rate. The legacy loan market is at greater risk of rising defaults due to the concentration of riskier borrowers from 2006 and 2007 who were able to access tighter spreads and higher levels of leverage than the high-yield market could accommodate at the time.
However, further spread compression may entice riskier lower B‟ or CCC rated issuers from the leveraged loan market to issue high-yield bonds. Such developments tend to signal the end of cycle in European high yield and a period of yield and spread widening together with subdued new issuance. To date in 2013, the market is accepting lower quality instruments from higher quality borrowers, such as Sunrise Communications Holdings SA (BB−/Stable) recent PIK note (B− instrument rating). When the market tests low-quality instruments from low-quality borrowers the cycle will be set to return." - source Fitch

The European and US High Yield Market, new issuance and yields - source Fitch:

Using again our "Pain & Gain" title analogy, we would like to further delve into our analysis of the "Japonification" of credit in Europe and the difference with the US where we are seeing re-leveraging at play in the credit space.

For instance, many pundits are wondering how come peripheral EMU bond yields and peripheral bonds have been performing so strongly when indices such as the FTSE Italian bank index is still flat at 10,000.

For us, it is very simple, deleveraging is generally bad for equities and in particular financial stocks, but good for credit assets. We discussed this very subject back in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out."

Why would we have had a rally in Italian banks? It doesn't make sense. For us a bank is a leverage play on the economy, it is the second derivative of a sovereign. No credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and no earnings for banks. Banks in peripheral countries had no choice but to shrink their loan books, reducing therefore their profitability and ROE.

European Banks ROE by countries from 2005 to 2011 - source Bloomberg - Macronomics:

Nota Bene: 2011 data for Germany not available. McKinsey & Co. said in its bank sector annual report. European bank average returns on equity were 15% to 17% in 2005-07, vs. 7% to 9% currently. With the revenue outlook poor, further cost cuts remain a key profitability lever. Median ROE in 2011 in the European Union was 2.2%.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 1.2% inflation rate is telling you hence the ECB rate cut this week. But, once again ECB is behind the curve courtesy of the stupid European Banking Association decision of imposing a 9% Core Tier 1 threshold to European banks to be reached by June 2012, which precipitated a credit crunch in peripheral countries, leading to a surge in unemployment, bankruptcies and rapid rise in nonperforming loans.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse in 2011). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen in the European banking space and other accounting tricks...). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios in peripheral countries.

Therefore in Europe, you have been much better off buying senior financial corporate bonds as part of the reflation "whatever it takes" trade in this deflationary environment than peripheral financial stocks. As seen in Japan in the past, credit outperforms equities in a deflationary environment.

Peripheral banks equities = Pain

Peripheral banks senior financial bonds = Gain

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":

Whereas credit wise, European peripheral financials are deleveraging, hence the performance of their bonds ("Gain" - Love) rather than their equities ("Pain"- Hate), what we are starting to see in the US is leverage rising as indicated by Fitch, in their recent US High Yield Default insight from March 2013:

"Credit Gains Hit Speed Bump:
In the March 2013 edition of the “Fitch Ratings/Fixed Income Forum Senior Investor Survey,” a majority of investors saw U.S. corporate leverage moving higher over the coming year and expected some credit deterioration across both high grade and high yield. Fitch’s recurring analysis of the aggregate financial performance of a large sample group of speculative grade companies shows that leverage began to turn up in 2012 — a product of higher debt balances and sluggish EBITDA growth (see Debt / EBITDA chart below).

In the second half of the year, in fact, the number of companies in Fitch’s sample reporting year-over-year increases in EBITDA (approximately 55%) had fallen to the lowest level in three years and was on par with the share reporting year over year increases in total debt (also 55%) (see Companies Reporting Increases in Debt and EBITDA chart below). 

Rating trends further confirm this pattern, offering a more complete picture of the direction of credit quality. Fitch recorded more U.S. corporate downgrades than upgrades in 2012. In the first quarter of this year rating activity was roughly even for speculative grade borrowers, and so it appears that the negative rating drift has stabilized, but trends remain lackluster, especially compared with 2010 and 2011 activity when credit quality was more firmly on the upswing. Also notable, the volume of bonds rated ‘CCC’ or lower is now $237.5 billion, up from $226.5 billion at the end of 2012 and $196.8 billion at the end of 2011. Even absent aggressive precrisis transactions, there is still plenty of organic sensitivity to the subpar domestic and global economic environment. An offset to this is funding. Thanks to the Fed’s commitment to low interest rates and the demand it has created for yield product, companies have been able to successfully push out bond and loan maturities. This provides a meaningful support for keeping default rates low in the near term."

In terms of flattening yield curve, indicative of the credit cycle, we think as credit investors you should start monitoring the flattening of CDS curves. As a market maker commented recently:
"1 year and 2 year CDS curves are flattening, only a matter of time before 3 year versus 5 year curves does the same and flatten."

We have of course seen this movie before in the credit space in the heyday of the credit bubble build up in 2006 and 2007.

So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door. As Aristotle put it, our aim, being wise we think, is not to secure pleasure, but to avoid pain, which will no doubt materialise at some point.

On a finale note, Mario Draghi ambitions to revive the real economy and corporate lending that is. The LTROs after all amounted to "Money for Nothing":

"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet."

Meaning plenty of liquidity impact (steroids) for banks (our European Sun Gym gang which have a taste for blood and money) but confirming our 2011 fears of credit contraction for corporates and households (Italy and Spain) - source Bloomberg:

"Corporate loans across the euro zone fell more than 350 billion euros ($460 billion) to March's total of 4.5 trillion euros from January 2009 highs. ECB President Mario Draghi's lowering of the marginal lending rate and hint at reviving European Asset-backed Securities mark early steps toward enlisting banks to lend-again. An ABS market would enable banks to package new lending into an ABS structure and post with the ECB to access further funding." - source Bloomberg.

As far as we are concerned, the deflationary forces at play and the unemployment levels in Europe cannot be addressed by ZIRP for the following "creative destruction reasons" as indicated by CreditSights in their recent Sovereign Analysis from the 1st of May entitled -If the ECB doesn't mind Spain deficit, nor do we":

"Spanish non-financial corporates alone saved the equivalent of 3.3% of GDP last year. That difference between corporates' revenues and expenses was used to pay down debt. Spanish, non-financial corporates have net debts equivalent to 129% of GDP. But it comes at the expense of Spanish households'. In the process of using revenues to pay down debt, corporates are ensuring that they aren't spending it and in the vast majority of cases won't not generate incomes for households. Those cut backs in investment spending are contributing to the decline in wages and rise in unemployment.

Unemployment has now reached 27.2% as of the first quarter. And wages have fallen by 1% over the past year. The decline in incomes mean that household savings have fallen from 6% of GDP in 2009 to 1% of GDP in 2012 as they have been forced to fall back on savings to be able to maintain spending. While households added €22 bn in financial assets in 2011 they reduced their holding of financial assets by €15 bn in 2012. That swing from saving €22 bn to dis-saving €15 bn contributed €37 bn to household spending and meant that year on year it rose by 0.2% in nominal terms rather than falling by more than 5.5%." - source CreditSights

 

Since 2008, you have seen creative destruction at play, meaning companies have preserved their margins by doing more with less people. Some job will just not return. What is the benefit of QE and ZIRP on structural unemployment? Zero so far:

ZIRP isn't only a European problem in this credit "japonifiaction" process at play. It is also the case in the US.

In fact productivity in the US has been rising as companies have been indeed preserving their margins by managing very tightly their labor costs and adapting to the low growth environment they face as reported by Shobhana Chandra in her Bloomberg article from the 2nd of May - Productivity in U.S. Rises as Companies Try to Cut Labor Costs:

"The productivity of U.S. workers rose in the first quarter as companies focused on containing labor expenses.
The measure of employee output per hour increased at a 0.7 percent annual rate, after dropping 1.7 percent in the prior three months, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey of economists called for a 1 percent advance. Expenses per worker increased at a 0.5 percent rate after jumping 4.4 percent.
Employers tried to control expenses by making do with their existing staff as demand grew in the January to March period. The emphasis on wringing efficiency gains may mean hiring will take time to accelerate, particularly as across-the board federal budget cutbacks and higher payroll taxes restrain the world’s largest economy." - source Bloomberg.

By keeping interest low to promote investment, like the Fed is also currently doing, full employment would therefore be "attainable" in the pure Keynesian tradition. For Keynes, the velocity of money should move together with the level of economic activity (and the interest rate). Well guess what. It isn't.

Why?

Credit growth is a stock variable and domestic demand is a flow variable.

Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?

The only country in Europe we can think of which tackles efficiently structural unemployment by retraining the labor force is Sweden.

Why would the US labor participation rate in the US increase?

If the cost of capital is not priced but set by central banks, how can capital be efficiently deployed to innovation and not "mis-allocated"?

 

MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.).

Monetary policy at the moment is a desperate race. They are increasing money supply but velocity keeps falling. So the Fed’s problem is best understood as one of trying to bend this velocity curve.

Alan Greenspan made mistakes after mistakes, bubbles after bubbles, central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate.

Pain in employment levels - Gain in financial markets.

"Prefer a loss to a dishonest gain; the one brings pain at the moment, the other for all time." - Chilon


Stay tuned!

Credit / Equities, different messages between the USA and Europe

"It is not best that we should all think alike; it is a difference of opinion that makes horse races." -   Mark Twain

In the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit where profit taking has been happening and weighting on the market for the last two weeks as per the chart below - source Bloomberg:

 Chart 1 - S and P 500 versus the two principal credit ETFs: HYG for High Yield and LQD for Investment Grade in the US.

In Europe, the message sent accross by the credit market has been more mixed. Investment Grade has under-performed High Yield year to date but less so than in the US (see chart below) - source Bloomberg:

Eurostoxx 50 (in red) versus Itraxx Main Europe CDS index (investment grade risk gauge) and Itraxx Financial Senior CDS index (investment grade financials senior risk gauge) as well as versus Itraxx Crossover CDS index (High Yield risk gauge).

In Europe, the financial part of the "investment grade" bucket has been clearly underperforming due to renewed pressure from peripheral countries (Spain and Italy). 

Conclusions:
In the US it seems there has been a real signal of cross asset "rotation / re-allocation" with an inversion of the correlation between Investment Grade / Equities.

In Europe, the correlation between  Credit versus Equities seems to have moved back since Friday into negative territory with renewed nervousness in European equities markets.

Is it  indicating the end, or is it simply marking a pause, in the outperformance of European equities versus US equities which started last summer? We wonder.

One interesting point is that in the Investment Grade space, as indicated by the growing spread difference between the Itraxx Main Europe 5 year CDS index and its US counterpart CDX IG 5 year CDS index, now 25 bps apart, Europe investment grade is now underperforming US investment grade - source Bloomberg:

"It's the niceties that make the difference fate gives us the hand, and we play the cards."  

- Arthur Schopenhauer

Stay tuned!

Credit / Equity / Volatility - Looking at this week's divergence

"There is something pagan in me that I cannot shake off. In short, I deny nothing, but doubt everything." - Lord Byron 

This week we have been witnessing a significant widening move in credit over the last few days, not only in the CDS space but also in the cash space, with the basis between cash and CDS remaining stable.

Several primary deals which have been priced aggressively since the beginning of the year are underperforming in the secondary market, generating some selling pressure particularly on investment grade credit in a very thin market, liquidity wise.

At the same time equities are not moving significantly, and both realized volatilities as well as implicit volatilities continue to fall day after day.

Itraxx Main Europe (Investment Grade risk gauge in Europe for 125 entities), Eurostoxx 50 index and Eurostoxx 3 month ATM (At The Money) Implied volatility in the bottom graph - source Bloomberg:

Two possible explanations:

1. Credit is predicting a correction in equities (often the case) and the profit-taking we are seeing will spread to equities.

2. There is a real movement behind this "rotation / re-allocation" from credit / fixed income towards equities, which includes a durable inversion in classical correlations between Credit / Equity / Volatilities.

To be continued...

Stay tuned!

Japan, where credit is leading equities...

"It is better to meet danger than to wait for it. He that is on a lee shore, and foresees a hurricane, stands out to sea and encounters a storm to avoid a shipwreck." - Charles Caleb Colton 

Back in our conversation "Saint-Elmo's fire", our good cross asset friend indicated to us an interesting correlation between the Japan Nikkei index and Japan's Itraxx 5 year CDS since the beginning of March. The index had been falling whereas at the same time, Japan's Itraxx CDS had been rising. The bottom graph indicates so far a fairly muted volatility for the Nikkei index:

As one can see from the above, the Japanese Itraxx CDS has been rising steadily (inverted in the graph for comparison purposes with the Nikkei index) while volatility has remained so far muted on the Nikkei index.

Itraxx Japan CDS climbing - source Bloomberg:

As a reminder from our conversation "Ecce Creditor" from March from Cheuvreux analyst Jolyon-Charles Montague his note "Atlas shrugged" on the 7th of March:

"Japan provides two important lessons for European investors: first, a case study of the perils of failing to achieve structural reform; second, how to invest in and trade a 20-year bear market. We conclude that for the current rally to continue beyond 2012 structural reform must be implemented, deflation averted and regulatory forbearance reversed: no small feat. It is often underappreciated that in 1989 Japan's net public debt to GDP was just 14.4% and the major driver for its explosion was a lack of tax revenue not fiscal largesse. Europe arguably is in a worse position than Japan as it has little room to raise taxes. Furthermore, Japan's government spending excluding social security and interest payments is among the lowest in the world. Given an aging population, Europe is on the verge of experiencing the same surge in social security spending."

Also in our conversation "Structural Instability" we looked at correlations between credit and equities and Japan stood out in particular. Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.

We believe once again credit is a leading indicator particularly when looking at Japanese equities.

Chart Volatility 6 months ATM Nikkei vs CDS ITRAXX JAPAN (50 entities versus 225 names) - source Bloomberg:

The recent Itraxx Japan roll impact on the widening of the Itraxx Japan index amounted to 20 bps of the widening move.

According to our good cross-asset friend, the correlation between the Nikkei volatility and credit spreads represented by the Itraxx Japan index has not been recently materially significant but, the widening of Japanese credit spreads cannot be ignored. In a very bullish credit environment, Japan is the only region (apart from peripheral Europe) where credit spreads are closer to the higher levels reached during the crisis of 2008/2009. This on-going weakness reflects deteriorating fundamentals for Japanese corporate companies such as Utilities suffering since Fukushima, struggling exporters courtesy of a very strong currency with private households hoarding cash, and specific companies facing difficulties such as Sharp and Sony. 

- source CMA cds data provider.

Therefore we believe this relationship warrants close monitoring. A very important point to make is that Japanese structured products (Uridashi) are totally driving the Nikkei's volatility as long as we are in a range 8,000 / 10,000 on the Nikkei index. Also please note Itraxx Japan has 50 names versus 225 names for the Nikkei index, further investigation in the components in sectorials bias would be needed in our exercise.

The Tokyo Stock Price Index commonly known as TOPIX is tracking all domestic companies of the exchanges First Section (1669 domestic companies). We find there is no opposition between Nikkei and Topix spot prices versus credit.

From the below, and following a similar exercise / analysis, we can find a similar relationship with credit, namely a high correlation in spot prices but not in volatility.

CDX Japan / TOPIX:

Correlation at -82.24%

CDX Japan / 12 months ATM TOPIX Volatility:

Correlation at 18.94%

We can therefore conclude that our Japanese "uneasiness" or discomfort courtesy of many years of "easiness" is indicative of the growing deterioration of some Japanese corporates, namely the ones being quoted in the CDS market. Globally, Japanese corporates remain "cash" rich but nevertheless the cracks are beginning to show in relation to Japan. Japanese output fell by 1.3% in July and Japan is headed for contraction this quarter.

Japanese Sovereign CDS 5 year evolution since 2004 - source Bloomberg:

The Japanese fight against deflation goes on...

On a final note in the latest spat between China and Japan, trade wise, China looks to have the upper hand:

"Japan’s increased dependence on China for export sales gives officials in Beijing the upper hand in a territorial dispute that triggered street protests and forced Chinese units of Japanese companies to close plants. The CHART OF THE DAY compares Japan’s exports to China, the European Union and the U.S. measured in billions of yen, showing sales to China more than doubling between 2002 and 2011 as the nation became the No.1 market. Exports to America dropped by almost one third and EU demand was little changed. The lower panel tracks nominal gross domestic product of the Asian countries, with China surpassing its neighbor as the world’s second-largest economy in 2010 in dollar terms, data compiled by Bloomberg show. China’s share of Japanese exports doubled over the decade to 20 percent. By contrast, the U.S. bought about 15 percent of Japan’s exports last year, half the proportion in 2002. The shift underscores China’s clout in a fracas over control of islands called Diaoyu in Chinese and Senkaku in Japanese."  - source Bloomberg

"Every government has as much of a duty to avoid war as a ship's captain has to avoid a shipwreck." - Guy de Maupassant 

Stay tuned!

Risk-Off Correlations - When Opposites attract

"Commodities tend to zig when the equity markets zag."
Jim Rogers

Looking at the recent sell-off in broad asset classes with the spill-off from the ongoing European crisis, we thought it would be interesting to look into asset correlation movements during "Risk-Off" periods such as today. We already touched in 2011 on asset correlation during the sell-off experienced in our conversation "Misery loves company".

More recently in our conversation "St Elmo's fire", we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

We argued at the time:
"We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern."
Indeed, both SPX and Oil prices are lower, with Oil dropping another 1.67% toady to 86.35 dollars.

We also indicated that Oil prices were poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss and Son Inc.’s chief executive officer as reported by Bloomberg:

"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years." - source Bloomberg.

Commodities, like in 2011, have experienced some significant retracement in conjunction with equities with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30 last week. The metal was 1.5 percent lower last week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low as well and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg. Even Gold Bullion wasn't spared and declined 1.9 percent last week as the dollar advanced 1.1 percent against a six-currency basket including the euro, which is poised for its biggest weekly drop in five months versus the U.S. currency according to Bloomberg.

Moving back to Oil and SPX, it seems other pundits as well are following the same disconnect between Oil and SPX as indicated by the below graph from Daiwa produced on Bloomberg, wondering:

** 3yr OIL V SPX: SPX to reset? ** Or Oil to bounce?

Truth is, in similar fashion to 2011, positive correlation between growth assets is most notable when investors are most concerned about risk according to AMP Capital's Oliver - source Bloomberg:

By Sungwoo Park and Saeromi Shin -May 31 (Bloomberg):
"The relationship between commodities and equities is the strongest in more than a year and near a 16-year record, as risks posed by Europe’s debt crisis and a global slowdown make the asset categories “more closely intertwined.”
The CHART OF THE DAY shows the 200-day correlation coefficient between the Standard and Poor’s GSCI Spot Index of 24 raw materials and the MSCI All-Country World Index of shares rose to 0.73 on May 25, the highest since January 2011 and near the strongest since at least 1994, data compiled by Bloomberg show. A correlation of 1 indicates the gauges move in lockstep, a value of zero shows there is no relationship.
When investors are most concerned about risk, “positive correlation between growth assets is most notable,” said Shane Oliver, head of investment strategy at AMP Capital Investors Ltd., which has almost $124 billion under management. “Everyone is looking at the same threats to growth, and so they are all selling together.”
The S and P GSCI index declined 4.2 percent this year through May 29 while the MSCI equities gauge gained 1.5 percent in the period. By contrast, the Dollar Index, a measure of the greenback against six currencies, touched a 20-month high on May 25. Investors are seeking safer assets, such as the dollar, as Europe wrestles with Greece’s debt and the possibility of that nation exiting the euro. Also of concern is the slowest economic expansion in about three years in China, the world’s biggest consumer of metals and cotton. Copper slipped to a four-month low last week, while cotton tumbled to a two-year low. Commodities and stocks have become “far more closely intertwined” as resources have taken on a greater role amid China’s economic expansion and increasing consumption in emerging-market nations, Oliver said. In 2000, after a 25-year commodity bear market, resource companies had low weightings in share gauges. “This has now reversed,” he said. When global risks are perceived as limited, “individual assets are largely driven by their own fundamentals and so the correlation between growth assets such as equities and commodities was low,” Oliver said. “In the current environment of heightened macro instability due to debt problems in Europe and the U.S., this is no longer the case. It’s either ‘risk on’ or ‘risk off’ with growth assets moving together.”

In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar - source Bloomberg:

According to John Detrixhe from Bloomberg on the 29th of May:

"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks.

From last year’s low on July 27, the greenback has risen against all 16 of its major peers. Intercontinental Exchange Inc.’s Dollar Index surged 12 percent, higher now than when the Fed began creating dollars to buy bonds under its extraordinary stimulus measures at the end of 2008.

International investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. The U.S. is one of only five major economies with credit-default swaps on their debt trading at less than 100 basis points, meaning they are viewed as almost risk free. A year ago, eight Group-of-10 nations fit that category, data compiled by Bloomberg show."

From the same article:
"The greenback’s share of global foreign-exchange reserves climbed in the last three-months of 2011 to 62.1 percent, the highest since June 2010, while holdings of euros fell to the lowest since September 2006 at 25 percent, according to the latest quarterly data from the International Monetary Fund.
Foreign official holdings of U.S. government debt increased in each of the first three months of 2012, climbing by 3.24 percent to $3.73 trillion in the best start to a year since2009, according to data from the Treasury Department." - source Bloomberg.

Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet.

"Which would you rather have, capital lined up on your borders, trying to get into your country or trying to get out of your country? We are the capital magnet of this planet and we are the savior for not only people, for not only freedom, but also for capital."
Arthur Laffer

Stay tuned!

Follow up on our Tale of Three Volatilities - Treasuries vs Equities and Forex

In our recent post "Treasuries vs Equities and Forex volatility - A Tale of Three volatilities", from the 21st of March, we looked at a historical chart showing the relative valuations of benchmark indicators for short-term implied vols in the three main asset classes (equities / forex / rates):
-Rates : Merril Lynch’s MOVE Index showing the trend in 1-mth atm implied volatility 2 / 5 / 10 and 30Y Treasuries options.
-FX : Credit Suisse’s CVIX Index showing the trend in FX main pairs atm 3month implied volatility on 9 major currency pairs.
-Equities : SPX 3mth options atm implied volatility (much more reliable than the VIX which is currently polluted by several technical factors).

Our good cross-asset friend argued at the time that disconnections in cross-asset vol markets generally do not last long. The rebound in US Treasuries rapidly led to a fast correction of Implied Volatilities for Rates as indicated in the updated graph enclosed below - source Bloomberg:

The small sell-off in US Treasuries had led to a strong spike in Implied Volatilities for Rates, which was not followed by similar moves in other asset classes, namely equities and forex, unusual, given their extreme correlation in recent months.

"The lower you fall, the higher you'll fly."
Chuck Palahniuk

Stay Tuned!

Markets update - Credit - The European Overdiagnosis

"Analysis does not set out to make pathological reactions impossible, but to give the patient's ego freedom to decide one way or another."
Sigmund Freud

Following on our meditations on Bayesian outcomes, and the "European Principle of Indifference", it appeared to us appropriate this time around to focus on the unintended consequences of applying nonsensical decisions to nonsensical results, hence, we have decided this time around to use the analogy of overdiagnosis relating to our European issues:

"Overdiagnosis is the diagnosis of "disease" that will never cause symptoms or death during a patient's lifetime. Overdiagnosis is the least familiar side effect of testing for early forms of disease – and, arguably, the most important. It is a problem because it turns people into patients unnecessarily and because it leads to treatments that can only cause harm." - source Wikipedia

Indeed, this analogy seems to us particularly right relating to the current European and American "Balance Sheet Recession" which has been a recurring theme from Richard Koo, chief economist at Nomura Research Institute, as pointed out by Cullen Roche on Pragmatic Capitalism - "DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION":

"This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again."

So, in a longer credit conversation than usual, we will first have a credit overview given recent significant price action (tightening spreads and much better tone in the credit space), before dealing more directly with the current" European Overdiagnosis" and unintended consequences courtesy of my global macro friends at Rcube Global Macro Research, quantifying "The likelihood of a Euro Breakup" in their latest paper, which follows on their previous analysis of Eurozone's core issue, namely Unit Labor Cost Divergence, which we discussed in our "European Flutter".

The Credit Indices Itraxx overview - Source Bloomberg:

"The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 European banks and insurers now costs a record 120.5 basis points less than the Markit iTraxx SovX Western Europe Index of swaps on 15 governments. That compares with a 28 basis-point gap at the end of November and a previous high of 118 in July. Historically, it costs more to insure banks than governments." - source Bloomberg news - Abigail Moses and John Glover.

The Year of the Dragon should be rebranded the Year of the European Central Bank, given the significant tightening in credit indices which we have witnessed in Europe since the beginning of the year as indicated by Bank of America Merrill Lynch research - The ECB trade - 17th of January:

"The ECB funding “put”
Away from S&P’s downgrade distraction, we think funding stresses in the credit market have improved significantly over the last month. Three themes paint a better picture. Firstly, ECB 3yr LTROs have had big take-up, and more is to come.
Secondly, fixed-rate senior unsecured bank issuance has reached €15bn YTD, half of the entire 2H supply last year. And finally, as our banks colleagues highlight, government guarantee schemes can be a powerful solution to a bank funding crisis. With the ECB helping to transform funding pressures in credit, we think short-dated spreads can keep rallying."

As indicated above the fall in the Itraxx Financial Senior 5 year index has been significant versus the SOVx 5 year index (relating to 15 European sovereign CDS) courtesy of the breakdown in the correlation between Sovereign and credit spreads, as indicated by Bank of America Merrill Lynch in their report:

"Sovereign and credit spreads - the correlation is finally breaking
Thanks to ECB intervention, credit spreads have been much less correlated to sovereign spreads over the last month (although still positive). In fact, our work shows that the correlation between bank and sovereign spreads has fallen from 90% in mid December last year, to 40% currently. This isn’t far from the lowest correlation between the two since the start of 2010. How long this lasts will ultimately be a function of the outlook for peripheral sovereign debt, given banks’big exposure to the periphery."

In fact as my good macro friend pointed out early January, it is interesting to track the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

Volatility has been falling faster than the Itraxx Crossover index and the index is clearly trying to catch up at the moment.

In relation to the liquidity picture, it has somewhat  improved as indicated in our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

New reserve period for deposits started on the 18th. It will be significantly important to track upcoming peripheral government bonds auctions, given that, while the ECB's intervention is clearly supportive for banks, volatility will depend on the Greek PSI outcome, upcoming downgrades for banks and corporate rating downgrades (following up on sovereign downgrades and which have already started).

As Bank America Merrill Lynch put it in a note published on the 16th of January - "Perhaps it's not so bad after all":
"Banks better placed than sovereigns?
It is certainly the case that European banks have a lender of last resort who is dealing very flexibly with their needs – something the ECB has so far proved reluctant to do with sovereign debt."

But, there is a catch and Bank of America Merrill Lynch report from the 17th is on target:
"It isn't all about European banks' sovereign exposure - its also about private sector lending, not just sovereign bond holdings."

"How long the low correlation between bank and sovereign spreads lasts will ultimately be a function of the outlook for peripheral sovereign debt, and Standard and Poor’s sovereign downgrades don’t help. Despite the ECB’s welcome funding, European banks’ exposure to sovereigns remains vast, as chart 7 shows. Note European banks’ large private sector lending to peripheral countries." - source Bank of America Merrill Lynch.

And Bank of America Merrill Lynch to conclude their note with the following advice in relation to credit in 2012: "a more trading, "macro-driven" credit market."

Truth is, while everyone is anxious about the results relating to the Greek PSI, Sovereign CDS wise, Portugal looks to be the ideal candidate for some additional haircuts as we indicated in our last post "The European Principle of Indifference".
Sovereign CDS, between Ireland and Portugal, a new record between both countries with a spread difference of 604 bps - source Bloomberg:

Portugal 5 year Sovereign CDS is now at 1245 bps, which according to CDS data provider CMA equates to a cumulated probability of default of 65.67% within 5 years.

Meanwhile, the disconnect between the 10 year German Bund and the Eurostoxx is still noticeable but today we saw some widening courtesy of German Bund 10 year spread climbing 9 bps and closing on the 2% level, (we noticed this disconnect first time around in November in our post "Mind the Gap...") - source Bloomberg:

In relation to our previous conversations relating to bond tenders and other steps taken by banks to shore up capital requrements (BBVA benefiting from a tax credit courtesy of a goodwill impairment as discussed recently), it was interesting to see the Wall Street Journal catching up with us in relation to the unusual steps taken by some European banks to raise capital in order to reach the 9% Core Tier 1 Capital threshold set up for June 2012 -
"Banks Seeking Capital Ideas - European Lenders Are Taking Unusual Steps to Meet Their Cash Requirements". But what also caught our attention was seeing Bank of America entering as well the raising capital game of bond tenders, offering to buy back 1.5 billion dollars worth of subordinated bonds on the 19th of January. As reported by Zeke Faux in Bloomberg:
"Bank of America is reducing long-term debt as Chief Executive Officer Brian T. Moynihan, 52, seeks to cut holdings, expenses and staff while raising capital to meet demands from regulators for a larger cushion against losses."
So European bankers, please take solace, you are not alone.
"The bank is offering about 95 cents for those securities, it said in the statement", according to Bloomberg, on 6.22% Subordinated bonds due in September 2026, which amounts to a smaller haircut than what we have witnessed in Europe recently on some subordinated bond tenders last couple of months.

But back to our main story, namely European politicians' "Overdiagnosis". What could happen if austerity bites too much, could it lead to Euro Breakup? This is what my friends at Rcube Global Macro Reasearch have recently worked on:

The Likelihood of a Euro Breakup

Since late November, the 2 year yields of both too-big-to-fail PIIGS have crashed (by 350bp for Italy and 320bp for Spain). This indicates that the latest initiatives to save the Euro – most notably the LTRO – have succeeded in lowering the perceived short-term risk of a Euro breakup. This is undeniably a bullish signal for risky assets in the short term. On the other hand, 10 year yields remain stubbornly high, especially in the case of Italy (which is still trading at around 6.5%). This shows that the market believes (as do we) that the question of the Euro’s long-term viability remains unresolved. In order to quantify the likelihood of a Euro exit for each endangered country, we have built a simple model based on CDS spreads and excess unit labor costs. Before showing the model itself, let’s explain why we don’t believe that solving the PIIGS’ government debt problems (through ECB initiatives and fiscal austerity) will be sufficient to prevent a Euro breakup.

In our recent paper about unit labor cost divergence (Macro Analytics 19/12/2011), we suggested that the Euro’s issues went beyond the current debt crisis. The Euro created competitiveness imbalances between Eurozone countries by preventing currency adjustments, which were prevalent in the period between the end of the Bretton Woods system (in 1971) and 1999:

We see some occasional swings, but the dominant pattern is a rather regular fall of most currencies – at different speeds - against the Deutsche Mark, the only exceptions being the Austrian schilling and the Dutch guilder. Unsurprisingly, countries whose currency deteriorated the most during this 28 year period were the PIIGS (the Greek Drachma led the trend with an impressive 95% devaluation against the DEM). When we look at unit labor costs compared to Germany between 1995 and 2012, we notice that countries’ rankings are close to being the opposite of their former currencies’ strength:

If we more thoroughly analyze the relationship between the devaluation rhythm of former currencies’ (+: depreciation, - : appreciation) during the 1971-1995 period and unit labor cost increases between 1995 and 2012, we find a Pearson correlation coefficient of 0.70, and a Spearman correlation coefficient of 0.87. This indicates a strong (albeit non-linear) relationship between those two data items.

Despite the stories about the Mileuristas in Spain, the Milleuristi in Italy and the 700€ Generation in Greece, wage-earners in the PIIGS faired relatively well on a productivity-adjusted basis during the 1995-2008 period, as if they were still being paid in a weak currency that justified regular wage increases. As an illustration of this, we recently learned that Italians now have the highest net worth amongst G8 countries, despite the dismal performance of Italy’s economy over the last decade (this is also a byproduct of Italy’s housing bubble).

Had the Euro never existed, it is fair to assume that PIIGS’ currencies would have naturally adjusted to compensate for their high relative unit labor costs. As countries renounced their ability to devaluate, their competitiveness suffered considerably. Even in the case of France, which is not (yet) considered as one of the PIIGS, its balance of trade went from +3.2% of GDP in 1997 to –3.0% in 2011.

By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.  

It is an understatement to say that finding a politically acceptable solution to restore labor cost balance within the Euro framework will be difficult. In addition to the deep cuts that are currently being imposed on government budgets, real wages will have to fall across the board (and not only minimum wages). As people tend to think about money in nominal terms (Keynes’ money illusion), it might end up being easier to find a smart (i.e. non chaos-inducing) way to return to a system of floating currencies, rather than to impose years of internal devaluations.

This is the main reason why we believe that the question of the Euro’s long-term survival goes beyond knowing whether the ECB will finally use its proverbial bazooka during the next 12 months. Even if Greece’s government debt was reduced to zero (which could end up being the case someday), it would not change anything regarding its current lack of competiveness (exports: 7% of GDP, imports 21%). As an anecdote, we recently read that Greece had to import olive oil from … Germany.

A simple model to assess market-implied Euro exit probabilities:

We believe that a large part of Eurozone countries’ CDS spreads reflect their long-term probabilities of exiting the Euro, rather than their default risk within the Eurozone. Indeed, even though we’re not sovereign debt experts, it seems evident to us that if a country was to exit the Eurozone and switch to a new currency, it would have to convert its government debts to the new currency. This would most likely constitute a default in legal terms for most countries[1], but we cannot imagine a country keeping a huge debt denominated in a foreign currency. This would create a Weimar-type vicious circle and would inevitably crush the new currency into oblivion.  Additionally, defaulting without exiting the Euro would not solve the competitiveness issue of many European economies (we’ll soon be able to check this theory with Greece).

If we assume that new currencies would have to devaluate to readjust their unit labor costs to their 1995 level, we can work out theoretical recovery values after redenomination (from which we take a haircut of 20% to take into account overshooting). We then calculate 1-year and 5-year Euro implied exit probabilities by using a simple formula for default probability (Default Probability = Spread / ( 1 – Recovery Rate) ]. This gives us the following implied exit probabilities for the main EZ countries[2] that have a 5 year CDS spread higher than 100:

Despite the rather simplistic assumptions we made in our calculations, these levels appear to be close to what we would have expected: in the short-term (1 year or less), exit probabilities are rather low for most countries, with the exception of Ireland and Portugal. Too much political capital has been invested in the Euro by the last two generations of politicians. Additionally, it would be a mistake to believe that the system is out of ammunition. In a fiat money world, the ECB cannot run out of Euros.  Everything ultimately depends on politicians’ (especially Merkel’s) willingness to “save the Euro”. On its own, the ultimate kick in the can (massive debt monetization) would certainly extend the Euro’s life for quite a few years.  

Consequentely, we believe that the Euro will muddle through for a while, in a climate of painful fiscal tightening for most European countries…

However, if as we fear will be the case, austerity plans do little to address the underlying competitiveness problems faced by many countries, their growth rates will remain anemic. Instead of the rosy “J curve” that would have been promised to justify deep cuts in government expenses, weak EZ countries will experience the dreaded “L”. Rather than going through another purge, some countries will then make the choice to exit the Euro. In this context, the 5 year implied exit probabilities do not appear to be exaggerated to us. 

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[1] Under ISDA rules, G7 countries (Germany, France and Italy) could decide to redenominate their debt without provoking a credit event.

[2] Outside from Greece whose default/exit probability is already 100%

"The physician must give heed to the region in which the patient lives, that is to say, to its type and peculiarities."
Paracelsus

Stay Tuned!